From the end of the Great Depression until the early 1970s, Keynesian economics provided the main inspiration for economic policy makers in Western industrialized countries. The influence of Keynes's theories waned in the 1970s, due to stagflation and critiques from Milton Friedman, Robert Lucas, Jr., Friedrich Hayek and other economists who were less optimistic about the ability of interventionist government policy to positively regulate the economy. The advent of the global financial crisis in 2008 prompted a resurgence of interest in Keynesian economics among policy makers. Paralleling this change, there has also been some rethinking of the relevance of Keynes' ideas among academics; however, the revival of Keynesian economics in academia has been more controversial and muted.

Background

Competing views on macroeconomic policy

Macroeconomic policy focuses on high level government decisions which affect overall national economies rather than lower level decisions concerning markets for particular goods and services. The Keynesian resurgence can be understood in the context of various competing perspectives from which policy recommendations originate. A key issue of contention is the optimal level of government intervention in economic affairs. For an overview on the different perspectives, see Liberal, Realist & Marxist.For more detail on specific systems of thought relevant to debate on this fiscal policy see Keynesian economics, Monetarism, Austrianism, New Classical economics, Real business cycle theory, and New Keynesian economics.

Over the last sixty years, most strikingly in the Anglo American economies but to a large extent worldwide, the two competing views receiving the most attention at policy-making level have been Keynesianism and monetarism. Commentators such as Sunday Times economics editor David Smith have gone as far to say the "entire economics debate could be characterized as a struggle between Monetarists and Keynesians".[5]

Monetarists advise minimal government intervention in the economy, apart from tightly controlling the money supply and publicizing targets for future modest expansion, thus setting expectations so as to reduce inflation. Monetarists also tend to favor free market policies such as clamping down on powerful labor unions, fairly light regulation, and generally small government – although not typically to the extremes favoured by other economic liberals such as Austrian school economists and libertarians.

Keynesians, in contrast to monetarists, tend to place greater importance on the role of fiscal policy over monetary policy in the ups and downs of the economic cycle; they advise government intervention, especially in a recession where the standard recommendation is for increased government spending - especially on capital projects such as infrastructure - and tax reductions in order to stimulate aggregate demand. In a boom they often suggest measures to dampen demand such as raising taxes and interest rates, and throughout the business cycle they prefer regulation of economic activity.

Keynesian economics evolved from the Keynesian Revolution. In contrast to the recent resurgence of Keynesian policy making, the revolution initially comprised a shift change in theory.[6] There had been several experiments in policy making that can be seen as precursors for Keynes ideas, most notably Franklin D. Roosevelt's famous "New Deal" (Roosevelt was US president from 1933 to 1945). These experiments however had been influenced more by morals, geopolitics and political ideology than by new developments in economics, although it is notable that Keynes had found some support in the US for his ideas about counter-cyclical public-works policy as early as 1931.[7] According to Gordon Fletcher, Keynes' General Theory provided a conceptual justification for 'New Deal'-type policies which was lacking in the established economics of the day - immensely significant as in the absence of a proper theoretical underpinning there was a danger that ad hoc policies of moderate intervention would be overtaken by extremist solutions, as had already happened in much of Europe.[6] Keynes did not however agree with all aspects of the New Deal; he considered that the almost immediate revival of business activity after the program's launch could only be accounted for by psychological factors, which are dangerous to rely on,[8] such as the boost to confidence by Roosevelt's inspiring oratory.

Since the 1940s the influence of Keynesian economics on government policy makers has both waxed and waned under pressure from free market economics, and from late 2008 appears to be waxing once again.[9][10]

The Keynesian ascendancy: 1941–1979

Clement Attlee (left, with George VI), British Prime Minister from 1945 to 1951, based his government's economic policy on Keynes' ideas.

While working on his General Theory, Keynes wrote to George Bernard Shaw saying "I believe myself to be writing a book on economic theory which will largely revolutionize, not I suppose at once but in the course of the next ten years – the way the world thinks about economic problems … I don't merely hope what I say, in my own mind I'm quite sure".[11] Professor Keith Shaw wrote that this degree of self confidence was quite amazing especially considering it took more than 50 years for the Newtonian revolution to gain universal recognition; but also that Keynes's confidence was fully justified.[12] Keynes provided the main inspiration for European and American economic policy makers from about 1941 to 1979. The 1950s and 60s, where Keynes's influence was at its peak, has been described as appearing in retrospect to have been a golden age.[9][13] In late 1965 Time magazine ran a cover article with the title inspired by Milton Friedman's statement, later associated with Nixon, that "We are all Keynesians now". The article described the exceptionally favourable economic conditions then prevailing, and reported that "Washington's economic managers scaled these heights by their adherence to Keynes's central theme: the modern capitalist economy does not automatically work at top efficiency, but can be raised to that level by the intervention and influence of the government." The article also states that Keynes was one of the three most important economists ever, and that his General Theory was more influential than the magna opera of his rivals – Smith's The Wealth of Nations and Marx's Das Kapital.[14]

Displacement by monetarism: 1979–1984

Milton Friedman: a leading critic of Keynes from the mid 1950s and an advocate of monetarism, his ideas achieved widespread acceptance in the 1970s.

The monetarist experiments in the UK in the early 1980s succeeded in bringing down inflation, but at the cost of unemployment rates in excess of 10%. Contrary to monetarist predictions, the relationship between the money supply and the price level proved unreliable in the short- to medium-term. The US Federal Reserve officially discarded monetarism in 1984[19] and the Bank of England likewise abandoned its sterling M3 money targeting in October 1985.

The early 90s saw some instances of fiscal intervention by policymakers in the US and UK, and such Keynesian remedies were never wholly dropped in Europe and other parts of the world. This period has been described as a time of pragmatism,[20] when, rather than following any one economic doctrine, policymakers chose whatever solution seemed to suit the particular circumstances they faced best. Yet free-market influences broadly sympathetic to monetarism remained very strong at government level in powerful normative institutions like the World Bank, the International Monetary Fund (IMF) and US Treasury, and in prominent opinion-forming media such as the Financial Times and The Economist.[21]

The Keynesian revival of 2008–2009

In the United States and Britain

In March 2008, free-market guru Martin Wolf, chief economics commentator at the Financial Times, announced the death of the dream of global free-market capitalism, and quoted Josef Ackermann, chief executive of Deutsche Bank, as saying "I no longer believe in the market's self-healing power."[22] Shortly afterward economist Robert Shiller began advocating robust government intervention to tackle the financial crisis, citing Keynes.[23][24] Macro economist James K. Galbraith used the 25th Annual Milton Friedman Distinguished Lecture to launch a sweeping attack against the consensus for monetarist economics and argued that Keynesian economics were far more relevant for tackling the emerging crises.[25]

A series of major bailouts followed, starting on September 7 with the announcement that the U.S. government was to nationalize the two firms which oversaw most of the U.S. mortgage market—Fannie Mae and Freddie Mac. In October, the British Chancellor of the Exchequer referred to Keynes as he announced plans for substantial fiscal stimuli to head off the worst effects of recession, in accordance with Keynesian economic thought.[26] Similar policies have been announced in other European countries, by the U.S., and by China.[27] This is in stark contrast to the scope given to Indonesia during its financial crisis of 1997, when the IMF forced it to close 16 banks simultaneously, prompting a bank run.[28]

Prominent Keynesian economists included the Nobel Prize winning Paul Krugman, described by the Financial Times as a "radical keynesian economist",[29]along with Robert Reich[30]Greg Mankiw[10] and Joseph Stiglitz.[10] Mankiw argued that Keynes was the economist who provided the greatest single insight into the crisis,[31] but later encouraged skepticism about a fiscal stimulus.[32]

The works on Keynes of Hyman Minsky,[33]Robert Skidelsky,[34] and Donald Markwell[35] were widely cited. Much discussion reflected Keynes's advocacy of international coordination of fiscal or monetary stimulus, and of international economic institutions such as the IMF and World Bank, which he had helped to create at Bretton Woods in 1944, and which many argued should be reformed at a "new Bretton Woods".[36] This was evident at the G20 and APEC meetings in Washington, D.C., and Lima, Peru, in November 2008, and in coordinated reductions of interest rates by many countries in November and December 2008. IMF and United Nations economists and political leaders such as British Prime Minister Gordon Brown advocated a coordinated international approach to fiscal stimulus.[37] The President of the World Bank, Robert Zoellick, advocated that all developed country pledge 0.7 percent of its stimulus package to a vulnerability fund for assisting developing countries.[38] It was argued (e.g. by Donald Markwell) that the absence of an international approach in the spirit of Keynes, or its failure, risked the economic causes of international political conflict which Keynes had identified (e.g. in the 1930s) coming into play again.[39][8]

In a speech on January 8, 2009, President Barack Obama unveiled a plan for extensive domestic spending to combat recession, further reflecting Keynesian thinking. The plan was signed by the President on February 17, 2009. There had been extensive debate in Congress concerning the necessity, adequacy, and likely effects of the package, which saw it being cut from $819 to $787 billion during its passage through the Senate.[40][41]

In various nations

A renewed interest in Keynesian ideas was not limited to Western countries. In a speech delivered in March 2009 entitled Reform the International Monetary System, Zhou Xiaochuan, the governor of the People's Bank of China, revived Keynes's idea of a centrally managed global reserve currency. Dr Zhou argued that it was unfortunate that Keynes's Bancor proposal was not accepted at Bretton Woods in the 1940s. He argued that national currencies were unsuitable for use as global reserve currencies as a result of the Triffin dilemma - the difficulty faced by reserve currency issuers in trying to simultaneously achieve their domestic monetary policy goals and meet other countries' demand for reserve currency. Dr Zhou proposed a gradual move towards adopting IMF Special Drawing Rights (SDRs) as a centrally managed global reserve currency.[42][43]Dr Zhou's view was echoed in June 2009 by the IMF[44] and in September was described by the Financial Times as the boldest statement of the year to come from China.[45]

In an widely read article on dollar hegemony published in Asia Times On Line on April 11, 2002, Henry C.K. Liu asserted that "The Keynesian starting point is that full employment is the basis of good economics. It is through full employment at fair wages that all other economic inefficiencies can best be handled, through an accommodating monetary policy."[46]Liu has also advocated that Chinese exports be denominated in Chinese currency (RMB) as a step to free China from the constraints of excessive reliance on the dollar.[47][48]

Effectiveness

China was one of the first nations to launch a substantial fiscal stimulus package, estimated at $586 billion spread over two years,[49] and in February 2009 the Financial Times reported that both government officials and private investors were seeing signs of recovery, such as rises in commodity prices, a 13% rise in the Chinese stock market over a period of 10 days, and a big increase in lending – reflecting the government's success in using state-owned banks to inject liquidity into the real economy[50].

As late as April, central bankers and finance ministers remained cautious about the overall global economy, but in May 2009 the Financial Times reported that according to a package of leading indicators there were signs that recovery was imminent in Europe too, after a trough in March. The US was one of the last major economies to implement a major stimulus plan, and the slowdown there looked set to continue for at least a few more months[51].There was also a rise in business and consumer confidence across most of Europe, especially in the emerging economies such as Brazil, Russia and India.[52]In June, the OECD reported improvements to the global economic outlook, with overall growth forecast for 2010 instead of a small contraction. The OECD gave the credit to stimulus plans, which they warned should not be rolled back too swiftly.[53]The IMF also reported a better than expected global economic outlook in July, though warning the recovery is likely to be slow. Again they credited the "unprecedented" global policy response and echoed the OECD in urging leaders to avoid complacency and not to unwind recession fighting fiscal and monetary policy too soon.[54][55]In a widely syndicated article published in August 2009, Paul Krugman announced that the world had been saved from the threat of a second great depression, thanks to "Big Government".[56]The US economy emerged from recession in the third quarter of 2009, which the Financial Times credited to the stimulus measures.[57]In November managing director of the IMF Dominique Strauss-Kahn again repeated the warning against exiting from the stimulus measures too soon, though the Financial Times reported significant differences had emerged even within Europe, with senior members of the European Central Bank expressing concern about the risk of delaying the exit for too long.[58]On 8 December 2009, President Obama unveiled what the Financial Times described as a "second stimulus plan" for additional job creation[59]using approx $200 billion of unused funds that had been pre-approved for the Troubled Asset Relief Program. The same speech saw the President advise that the initial stimulus had already saved or created 1.6 million jobs.[60]In an article looking back at 2009, economics professor Arvind Subramanian wrote in the Financial Times that economics had helped to redeem itself by providing advice for the policy responses that successfully prevented a global slide into depression, with the fiscal policy stimulus measures taking their "cue from Keynes".[61]

Calls for the resurgence to extend further

In 2009 there were several books published by economists advocating a further shift towards Keynesian thinking. The authors advocated further reform in academic economics,[9][62][63] policy making [9][62][63] and even the public's general ethics.[9]Theoretical arguments regarding the relative merits of free market versus mixed economy policies do not always yield a clear conclusion. In his 2009 book Keynes: The Return of the Master, economic historian Lord Skidelsky has a chapter comparing the performance of the world economy between the Golden Age period of 1951–1973 where Keynesian policies were dominant with the Washington Consensus period of 1981–2008 where free market polices were adopted by leading governments. Samuel Brittan of the Financial Times called this part of the book the key chapter for the practically inclined reader.[64]Using data from the IMF, Skidelsky finds superior economic performance on a whole range of metrics, except for inflation where he says there was no significant difference.[9]

Metric

Golden Age period

Washington Consensus period

Average global growth

4.8%

3.2%

Average global inflation

3.9%

3.2%

Average Unemployment (US)

4.8%

6.1%

Average Unemployment (France)

1.2%

9.5%

Average Unemployment (Germany)

3.1%

7.5%

Average Unemployment (Great Britain)

1.6%

7.4%

Skidelsky suggests the high global growth during the golden age was especially impressive as during that period Japan was the only major Asian economy enjoying high growth – it was not until later that the world had the exceptional growth of China and other emerging economies raising the global average.[9] Lord Skidelsky also comments that the golden age was substantially more stable – comparing slightly different periods, Martin Wolf found that in 1945–71 (27 years) the world saw only 38 financial crises, whereas in 1973–97 (24 years) there were 139.[65] Skidelsky also reports that inequality was generally decreasing during the golden age, whereas since the Washington Consensus was formed it has been increasing. He notes that South America has been an exception to general rise in inequality – since the late 1990s inequality has been falling there, which James Galbraith explains as likely due to the regions early "retreat from neoliberal orthodoxy".[9]

In his 2009 book The Keynes Solution, post-Keynesian economist Paul Davidson makes another historical case for the effectiveness of Keynesian policy, referring to the experience of the United States during the Great Depression. He notes how economic growth and employment levels increased for four successive years as New Deal policies were pursued by president Roosevelt. When government spending was cut back in 1937 due to concerns about the budget deficit, all the gains were lost in one year, and growth only resumed after spending increased again from 1938, as a response to growing acceptance of Keynes' ideas and later to the need for war spending. For Davidson, this experience "proves beyond a shadow of a doubt" that Keynesian policy has the power to deliver full employment and prosperity for a government's entire labor force.[62]

On November 8, 2008, Paul Davidson and Henry C.K. Liu co-authored an open letter to world leaders attending the November 15 White House summit on financial markets and the world economy urging reconsideration of Keynes' analytical system that contributed to the golden age of the first quarter century after World War II. The letter, signed by many supporting economists, advocates a new international financial architecture based on an updated 21st century version of the Keynes Plan originally proposed at Bretton Woods in 1944.

The letter ends by describing this new international financial architecture as aiming to create (1) a new global monetary regime that operates without currency hegemony, (2) global trade relationships that support rather than retard domestic development and (3) a global economic environment that promotes incentives for each nation to promote full employment and rising wages for its labor force.[66]

Criticism

Keynesian ideas have also attracted considerable criticism. While there has been broad consensus among international leaders concerning the need for co-ordinated stimulus, the German administration initially stood out in their reluctance to wholeheartedly embrace Keynesian policy.[67]

Critics focus on arguing that Keynesian policy will be counter-productive – reasons given include assertions that it will be inflationary, create more income disparity and cause consumers to rein in their spending even more as they anticipate future tax rises.[68][69][70][71]In 2009 more than 300 professional economists, led by three Nobel Laureates in economics, James M. Buchanan, Edward Prescott and Vernon Smith, signed a statement against more government spending arguing that "Lower tax rates and a reduction in the burden of government are the best ways of using fiscal policy to boost growth."[72]Robert Barro, an economics professor at Harvard University, has argued that stimulus spending may be unwise, claiming one of the factors the US stimulus package depends on for its effectiveness, the multiplier effect is in practice close to zero – not 1.5 as he says the Obama team were assuming – which means the extra employment generated by the stimulus will be cancelled out by less output and investment in the private sector.[73][74]A group of German economists have also argued that the size of the multiplier effect has been over estimated.[75]Edward Prescott [76] and fellow economist Eugene Fama[77] have also argued that the stimulus plans are unlikely to have a net positive effect on employment, and may even harm it. Jeffrey Sachs has argued that the stimulus and associated policies "may work in the short term but they threaten to produce still greater crises within a few years".[78]

There have also been arguments that the late 2000s crisis was caused not by excessively free markets but by the remnants of Keynesian policy.[79]Luigi Zingales of University of Chicago argues that "Keynesianism is just a convenient ideology to hide corruption and political patronage".[80] In February 2009, Alan Reynolds, senior fellow at the Cato Institute, acknowledged the resurgence, then proceeded to argue that evidence from various studies suggest Keynesian remedies will be ineffective and that Keynesian advocates appear to be driven by blind faith.[81]Austrian school economic historian Thomas Woods published a book, Meltdown, in 2009 which places the blame for the crises on government intervention, and blames the Federal Reserve as the primary culprit behind the financial calamity.[82]

Critics on the left question whether government policy has become sufficiently Keynesian – looking at the US for example they consider Obama's economic team to be disappointingly centrist, with its inclusion of economists who have previously been associated with support for the neoliberal or pro free market agenda, such as Jason Furman and Larry Summers.[83][84]From the radical left, sociology professor John Bellamy Foster has questioned whether the resurgence has been truly Keynesian in character, he suggests those few economists he regards as genuinely progressive such as James Galbraith are now far from the centre of government. He also asserts that it is to Marx, and not to Keynes, that society should look to for a full solution to economic problems.[85]

The Keynesian resurgence in academia

With a few notable exceptions - such as Robert Shiller, James K. Galbraith and Paul Krugman among others - the Keynesian resurgence has been largely driven by policy makers rather than academic economists. Until very recently mainstream economists have not generally favoured robust counter-cyclical fiscal policies. While the school of thought known as New Keynesian economics has dominated the teaching of macroeconomics at universities, New Keynesians largely believed that monetary policy was enough to stabilize the economy, and largely rejected the case for interventionist fiscal policy which Keynes had advocated. Some economists (primarily post-Keynesians) have accused the New Keynesian system of being so integrated with pro-free market neo-classical influences that the label 'Keynesian' may be considered a misnomer.[86]

Yet there has been a shift in thinking amongst many mainstream economists, paralleling the resurgence of Keynesianism among policy makers. The New York Times reported that in the 2008 annual meeting of the American Economic Association mainstream economists remained hostile or at least sceptical about the government’s role in enhancing the market sector or mitigating recession with fiscal stimulus - but in the 2009 meeting virtually everyone voiced their support for such measures.[87] However a substantial shift in opinion is less obvious in the academic literature. Speaking in March 2009, Galbraith has stated that he has not detected any changes among academic economists, nor a re-examination of orthodox opinion in the journals.[88]

The 2008 financial crisis has led some in the economic profession to pay greater attention to Keynes’s original theories. In February 2009, Robert Shiller and George Akerlof argued in their book Animal Spirits that the current US stimulus package was too small, as it does not take into account loss of confidence or do enough to restore the availability of credit. In a September 2009 article for the New York Times, on the lessons economists should learn from the crisis, Paul Krugman urged economists to move away from neoclassical models and employ Keynesian analysis:[89]

“

So here's what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit ... that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they'll have to do their best to incorporate the realities of finance into macroeconomics.